Outlook 2018: Fixed Income.

Fixed-income investors face another challenging year. The “easy money” policies implemented in the wake of the global financial crisis are ending as the world’s major central banks begin to cut back or even reverse easing measures.

Such moves will result in their net asset purchases dropping to zero by the end of 2018, potentially triggering greater volatility in nervous financial markets, as well as higher interest rates and increasing spreads between different categories of bonds.

The European Central Bank plans to end bond purchases altogether in September – unless the continent’s economy unexpectedly deteriorates. The ECB will reinvest the proceeds from maturing bonds in its portfolio, softening the impact of reduced purchasing.

ECB President Mario Draghi insists that loose monetary policy will remain necessary for some time – even though the Eurozone economy is now growing strongly – because inflation remains stuck well below the central bank’s targetofcloseto 2%.

Draghi expects interest rates to remain low even after bond purchases end, virtually ruling out a rate hike in 2018. However, indicators point to a very strong Eurozone recovery, which could push up inflation expectations. We therefore expect European yield curves to steepen over the year, with longer-term bond yields rising faster than short-term ones.

In October 2017, the US Federal Reserve began reducing its stockpile of bond assets by $10 billion a month, gradually increasing sales each quarter until they reach $50 billion a month. The Fed is also indicating that it intends to hike rates at least three times in 2018. That prospect is driving up short-term interest rates, though longer-term rates seem unlikely to rise much as long as US inflation remains subdued. So we expect short- and long-term US bond yields to converge toward the end of the year – and short-term rates could even go higher.

The US Treasury market has a powerful effect on government bond markets across the world and rising US yields will likely held to push yields higher in the UK.

In Japan, asset purchases are set to decline. Because the Bank of Japan already holds more than 40% of all government bonds, smaller purchases will be sufficient to keep interest rates low.

By late 2018, the end of net asset purchases and higher interest rates will likely make riskier bonds less attractive and widen the yield gap to safer investment-grade debt. This could hurt bond prices. Our advice is to lean towards short duration and higher quality fixed income exposure.

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